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In Markowitz’s (1952) setting, portfolio selection is driven solely by financial parameters and the investor’s risk aversion. This framework may however be viewed as too restrictive since, in the scope of Socially Responsible Investment (SRI)1, investors also consider non-financial criteria. This paper explores the impact of such SRI concerns on mean-variance portfolio selection. SRI has recently gained momentum. In 2007, its market share reached 11% of assets under management in the United States and 17.6% in Europe.2 Moreover, by May 2009, 538 asset owners and investment managers, representing $18 trillion of assets under management, had signed the Principles for Responsible Investment (PRI)3. Within the SRI industry, initiatives are burgeoning and patterns are evolving rapidly.In practice, SRI takes various forms. Negative screening consists in excluding assets on ethical grounds (often related to religious beliefs), while positive screening selects the best-SR rated assets (typically, by combining environmental, social, and governance ratings). Renneboog et al. (2008) describe “negative screening” as the first generation of SRI, and “positive screening” as the second generation. The third generation combines both screenings, while the fourth adds shareholder activism.
Fixed Income and FX Strategy
This paper measures the trade-off between financial efficiency and SRI in the traditional mean-variance optimization. We compare the optimal portfolios of an SR-insensitive investor and her SR-sensitive counterpart in order to assess the cost associated with SRI. Our contribution is twofold. First, we extend the Markowitz (1952) model4 by imposing an SR threshold. This leads to four possible SR-efficient frontiers: a) the SR-frontier is the same as the non-SR frontier (i.e. no cost), b) only the left portion is penalized (i.e. a cost for high-risk-aversion investors only), c) only the right portion is penalized (i.e. a cost for low-risk aversion investors only), and d) the full frontier is penalized (i.e. a cost for all investors). Despite its crucial importance, practitioners tend to leave the investor’s risk aversion out of the SRI story. Our paper on the other hand offers a fully operational mean-variance framework for SR portfolio management, a framework that can be used for all asset classes (stocks, bonds, commodities, mutual funds, etc.). It makes explicit the consequences of any given SR threshold on the determination of the optimal portfolio. To illustrate this, we complement our theoretical approach by an empirical application to emerging bond portfolios. The rest of the paper is organized as follows. Section 2 proposes the theoretical framework forthe SR mean-variance optimization in the presence of risky assets only. Section 3 adds a riskfree asset. Section 4 applies the SRI methodology to emerging sovereign bond portfolios. Section 5 concludes.
Fixed Income and FX Strategy